class: center, middle, inverse, title-slide .title[ # Principles of Macroeconomics ] .author[ ### ECO 2307 ] .date[ ### <em>Spring 2023</em> ] --- class: center, middle, inverse # Chapter 13 ## Aggregate Demand and Aggregate Supply Analysis --- ## Aggregate Demand and Supply Model .pull-left[ #### Where we've been: - How aggregate expenditure relates to production - How aggregate expenditure relates to aggregate demand #### Where we're going: - model long-run economic growth and also how real GDP is determined in the short run - extend the model of the economy in the short run in order to explain why the following fluctuate: - Real GDP - Employment - The price level - develop AD/AS model - explains short-run fluctuations in real GDP and price level ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_1.png" width="100%" style="display: block; margin: auto;" /> ] --- ## Aggregate Demand .panelset[ .panel[.panel-name[Downward Sloping] ### Why is the AD curve downward sloping? .pull-left[ **Four components:** `\(Y = C + I + G + NX\)` 1. **Primary assumption (G)** - government purchases are determined by the policy decisions of lawmakers - not affected by changes in price level 2. **Wealth effect (C)** - Implication: higher price level leads to lower consumption. 3. **Interest-rate effect (I)** - Implication: higher price level leads to lower investment. 4. **International-trade effect (NX)** - Implication: higher price level leads to lower net exports ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_1a.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Shifts] #### Shifts vs. Movement - AD shows relationship between the price level and real GDP demanded, *ceteris paribus* - Movement along curve - Price level changes - When change in prices is not caused by a component of real GDP changing - Shift - Some component of real GDP changes - For example, a change in government purchases #### Factors that shift demand: 1. Monetary Policy 2. Fiscal Policy 3. Households/Firms' Expectations 4. Foreign Exchange ] .panel[.panel-name[Monetary Policy] <img src="data:image/png;base64,#images/tab_13_1a.png" width="100%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Fiscal Policy] <img src="data:image/png;base64,#images/tab_13_1b.png" width="100%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Expectations] <img src="data:image/png;base64,#images/tab_13_1c.png" width="100%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Foreign Exchange] <img src="data:image/png;base64,#images/tab_13_1d.png" width="100%" style="display: block; margin: auto;" /> ] ] --- ## Aggregate Supply .panelset[ .panel[.panel-name[LRAS] .pull-left[ **Aggregate supply**: - the quantity of goods and services that firms are willing and able to supply - Long run and short run are different **Long-run aggregate supply (LRAS) curve**: - a curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied - Determined by - number of workers - level of technology - capital stock (factories, machinery, etc.) - Occurs at potential/full-employment GDP ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_2.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[SRAS] ### The Short-Run Aggregate Supply Curve .pull-left[ **Why SRAS slopes up** LRAS is vertical, but SRAS slopes upward--why? - Prices of final goods/services `\(\uparrow\)` => prices of inputs `\(\uparrow\)` *more* slowly - Also, some firms are *slow* to adjust prices when the price level changes (*sticky prices*) - Failure to predict changes in the price level **3 possible explanations:** 1. Contracts make some wages and prices “sticky”. 2. Firms are often slow to adjust wages. 3. Menu costs make some prices sticky. ] .pull-right[ #### How sticky are wages? <img src="data:image/png;base64,#images/ch_12/sticky_wages.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[SRAS Shifts] ### Shifts of the SRAS Curve versus Movements Along It .pull-left[ SRAS models price level and quantity of goods/services firms are willing to supply, *ceteris paribus* **Movements** - Change in price level not caused by factors that would otherwise affect SRAS **Shifts** - Expectations - Productivity/Technology - Supply Shocks ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_3.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Expectations] <img src="data:image/png;base64,#images/tab_13_2b.png" width="100%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Productivity] <img src="data:image/png;base64,#images/tab_13_2a.png" width="100%" style="display: block; margin: auto;" /> ] .panel[.panel-name[Supply Shocks] <img src="data:image/png;base64,#images/tab_13_2c.png" width="100%" style="display: block; margin: auto;" /> ] ] --- ## Macroeconomic Equilibrium in LR and SR .panelset[ .panel[.panel-name[LR Eq'm] ### Macroeconomic Equilibrium in the Long Run .pull-left[ LRAS shows the level of potential, or full-employment, GDP LR equilibrium is where - `\(AD = SRAS = LRAS\)` - GDP is at *full-employment* level - Note, for simplicity we assume no inflation and no growth ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_4.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[AD Decrease] ### The SR and LR Effects of a Decrease in Aggregate Demand .pull-left[ <img src="data:image/png;base64,#images/fig_13_5a.png" width="85%" style="display: block; margin: auto;" /> ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_5b.png" width="85%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[AD Increase] ### The SR and LR Effects of an Increase in Aggregate Demand .pull-left[ <img src="data:image/png;base64,#images/fig_13_6a.png" width="90%" style="display: block; margin: auto;" /> ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_6b.png" width="90%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Supply Shock] ### SR and LR Effects of a Supply Shock .pull-left[ <img src="data:image/png;base64,#images/fig_13_7a.png" width="75%" style="display: block; margin: auto;" /> ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_7b.png" width="75%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Covid-19] ### The Effects of the Covid-19 Pandemic .pull-left[ Point B was not the new SR equilibrium. Why? 1. Reduced consumption spending 2. Reduced investment spending 3. Reduced exports The pandemic caused SRAS and AD curves to shift left - the new SR eq'm occurred at point C, - real GDP fell to $17.3 trillion in the 2Q2020 - price level fell to 112.8 ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_8.png" width="100%" style="display: block; margin: auto;" /> ] ] ] --- ## Dynamic AD and AS Model .panelset[ .panel[.panel-name[Intro] ## Dynamic Aggregate Demand and Aggregate Supply Model Our model of aggregate demand and aggregate supply so far has been static, in the sense that: - Price levels were constant (no inflation) - There was no long-run growth We will now form a dynamic aggregate demand and aggregate supply model, incorporating: - Continually increasing real GDP, shifting LRAS to the right - AD also ordinarily shifting to the right - SRAS shifting to the right, except when workers and firms expect high rates of inflation ] .panel[.panel-name[Dynamic Model] .pull-left[ ### Dynamic AD and AS Model <img src="data:image/png;base64,#images/fig_13_9.png" width="100%" style="display: block; margin: auto;" /> ] .pull-right[ ### Dynamic AD and AS with Inflation <img src="data:image/png;base64,#images/fig_13_10.png" width="90%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Great Recession] ### Main Factors Causing the Recession of 2007-2009 .pull-left[ 1. The end of the housing bubble 2. The 2007 – 2009 financial crisis 3. The rapid increase in oil prices during 2008 ] .pull-right[ <img src="data:image/png;base64,#images/fig_13_11.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Oil Shock Example] The 1974-1975 recession is a good example of a supply shock affecting the economy. OPEC increased the price of a barrel of oil from under $3 to over $10. Assume that the aggregate demand curve did *not* shift during this time period. Use this information along with the statistics in the following table to draw a dynamic aggregate demand and aggregate supply graph showing macroeconomic equilibrium for 1974 and 1975. <table> <thead> <tr> <th style="text-align:right;"> Year </th> <th style="text-align:left;"> Actual_Real_GDP </th> <th style="text-align:left;"> Potential_GDP </th> <th style="text-align:right;"> Price_Level </th> </tr> </thead> <tbody> <tr> <td style="text-align:right;"> 1974 </td> <td style="text-align:left;"> $5.66 trillion </td> <td style="text-align:left;"> $5.69 trillion </td> <td style="text-align:right;"> 27.3 </td> </tr> <tr> <td style="text-align:right;"> 1975 </td> <td style="text-align:left;"> $5.64 trillion </td> <td style="text-align:left;"> $5.89 trillion </td> <td style="text-align:right;"> 29.8 </td> </tr> </tbody> </table> ] .panel[.panel-name[Oil Shock Solution] .pull-left[ <img src="data:image/png;base64,#images/ch_12/oil_shock.png" width="100%" style="display: block; margin: auto;" /> ] .pull-right[ `\(LRAS_{1974}\)` and `\(LRAS_{1975}\)` are at the levels of potential GDP for each year Macroeconomic equilibrium for 1974 - the `\(AD\)` curve intersects the `\(SRAS_{1974}\)` curve - real GDP of $5.66 trillion and a price level of 27.3 Macroeconomic equilibrium for 1975 - `\(AD\)` curve intersects the `\(SRAS_{1975}\)` curve - real GDP of $5.64 trillion and a price level of 29.8. ] ] ] --- ## Macroeconomic Schools of Thought .panelset[ .panel[.panel-name[Intro] .pull-left[ **New Keynesian Economics** - This is the AD/AS model - Emphasize the stickiness of wages and prices in explaining fluctuations in real GDP - A concept that Keynes did not include in his original model - John Maynard Keynes’ 1936 book The General Theory of Employment, Interest, and Money inspires the model we have addressed in this chapter. - Widespread acceptance during the 1930s and 1940s of Keynes’ model became known as the Keynesian revolution. ] .pull-right[ **Macroeconomic theory** - relatively less settled than microeconomic theory - developed as a separate field within economics after the Great Depression **Main theories** 1. Monetarist (Friedman, Chicago) 2. Neo-Classical (Chicago) 3. Real Business Cycle (Chicago) 4. Austrian (Hayak) ] ] .panel[.panel-name[Monetarist] .pull-left[ **The Monetarist Model** - The idea that the quantity of money should be increased at a constant rate - Milton Friedman (1940s) - Most fluctuations in real output were caused by fluctuations in the money supply - Therefore, the Federal Reserve should concentrate - less on interest rates and more on following a monetary growth rule - **monetary growth rule:** a plan for increasing the quantity of money at a fixed rate that does not respond to changes in economic conditions ] .pull-right[ <img src="data:image/png;base64,#images/ch_12/friedman.png" width="100%" style="display: block; margin: auto;" /> ] Monetarism is based on the quantity theory of money, which we’ll examine in the next chapter. ] .panel[.panel-name[Neo-Classical] .pull-left[ **The New Classical Model** - New classical macroeconomics emerged 1970s - it consists of the macroeconomic theories of Robert Lucas and others - Workers and firms have **rational expectations** - Workers and firms develop expectations about price levels. - If expectations are wrong, then the real wage will be too high or too low - This causes firms to reduce or increase employment respectively—recession or expansion - These fluctuations can be minimized - Help workers and firms to form correct expectations—again - Follow a consistent monetary growth rule ] .pull-right[ <img src="data:image/png;base64,#images/ch_12/friedman.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Real Bus. Cycle] **The Real Business Cycle Model** - The real business cycle model of the economy focuses on real, rather than monetary, causes of the business cycle. - Workers and firms form rational expectations about prices and wages - These adjust quickly to supply and demand - But main sources of fluctuations in real GDP are temporary productivity shocks - Aggregate supply is vertical even in the short run - Unaffected by the price level - Only supply shocks that affect the level of real output ] .panel[.panel-name[Austrian] .pull-left[ **The Austrian Model** - Began in the late nineteenth century with the writings of Carl Menger. - Was advanced by Ludwig von Mises and Friedrich von Hayek. - Superiority of the market system over economic planning - Hayek: Only the price system could use all the dispersed information to achieve efficiency - "Use of Knowledge in Society" **Theory of the business cycle:** ] .pull-right[ <img src="data:image/png;base64,#images/ch_12/hayak.png" width="100%" style="display: block; margin: auto;" /> ] - central bank-induced low interest rates cause the business cycle by prompting over-investment - Examples - Austrians argue the 2007-2009 recession fits this model. - They claim the Fed cut interest rates too low in fighting the 2001 recession. ] .panel[.panel-name[Marxism] .pull-left[ **Karl Marx (19th century German)** - Not mainstream economic thought - Labor theory of value: attributes all the value of a good or service to the labor embodied in it - Marx argued - market system would eventually be replaced by a Communist economy (workers control production) - How? - workers unable to afford an above-subsistence standard of living under large firms - so would rebel against exploitation by large firms ] .pull-right[ <img src="data:image/png;base64,#images/ch_12/karl_marx.png" width="100%" style="display: block; margin: auto;" /> ] ] .panel[.panel-name[Discussion] **Which school of thought is correct?** - We're pretty sure not Marxism - We don't know which mainstream school is correct **Evidence is inconclusive** - Many pieces of evidence can be interpreted in several different ways **The problem with macro is separating correlation and causation** - Cannot isolate particular elements to study - Cannot conduct controlled experiments **So, it is likely that debate about the applicability of schools of thought, and hence optimal policies for governments to pursue, will continue for the foreseeable future.** ] ] --- ## Keynes vs. Hayek .pull-left[ <iframe width="500" height="281" src="https://www.youtube.com/embed/d0nERTFo-Sk" title="Fear the Boom and Bust: Keynes vs. Hayek - The Original Economics Rap Battle!" frameborder="0" allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen></iframe> [Keynes v. Hayek: Round 1](https://youtu.be/d0nERTFo-Sk) ] .pull-right[ <iframe width="500" height="281" src="https://www.youtube.com/embed/GTQnarzmTOc" title="Fight of the Century: Keynes vs. Hayek - Economics Rap Battle Round Two" frameborder="0" allow="accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share" allowfullscreen></iframe> [Keynes v. Hayek: Round 2](https://youtu.be/GTQnarzmTOc) ]